Working Paper: NBER ID: w7516
Authors: Lars E.O. Svensson
Abstract: The paper discusses several issues related to how monetary policy should be conducted in an era of price stability. Low inflation (with base drift in the price level) and price-level stability (without such base drift) are compared, and a suitable loss function (corresponding to flexible inflation targeting) is discussed, including the index and level for the inflation target. Three ways of maintaining price stability are examined, namely (1) a commitment to a simple instrument rule, (2) "forecast targeting," and (3) monetary targeting. Both (1) and (3) are found to be inferior to forecast targeting in maintaining price stability. The benefits of credibility (private inflation expectations coinciding with the inflation target) are discussed. Credibility improves the tradeoff between inflation variability, output-gap variability and instrument variability and makes it easier for the central bank to meet its inflation target. The threat of deflation and a liquidity trap is examined. Transparent inflation targeting and a contingency plan with emergency measures, including a coordinated fiscal and monetary expansion, are likely to avoid a liquidity trap, but also contribute to escaping from one if already trapped.
Keywords: Monetary Policy; Price Stability; Inflation Targeting
JEL Codes: E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| commitment to a simple instrument rule (C36) | price stability (E31) |
| forecast targeting (C53) | price stability (E31) |
| credibility (D83) | trade-off between inflation variability, output-gap variability, and instrument variability (E31) |
| transparent inflation targeting (E31) | avoid or escape liquidity trap (E41) |